The European trading landscape has experienced more than its fair share of exchange downtime in recent months. From NYSE Euronext’s 40-minute outage in October to the London Stock Exchange’s four-hour breakdown on February 25, trading disruptions are becoming more common. However, despite a surge in alternative liquidity and the increasing sophistication of broker technology, keeping trading going through these incidents remains a challenge.

Richard Balarkas, Instinet Europe

For those bulge-bracket brokers with capital at their disposal, problems at stock exchanges force traders back to basics: picking up the phone. This was the case for Bank of America Merrill Lynch, which scaled up its traditional high-touch voice-broking franchise during the LSE’s outage to provide over-the-counter quotes for clients eager to trade in Lloyds TSB, which announced its fourth quarter results that day. Bank of America Merrill Lynch was able to facilitate 108% of the market’s normal trading volume in the shares of the UK bank.

Jonathan Beebe, head of Europe, Middle East and Africa equity flow trading at BofA Merrill Lynch, said: “The high-touch franchise is something we use every day. But we were able to scale up, home in on client demand and then create a verbal order book quoting two-way prices.”

Only a handful of the bulge-bracket firms are able to provide this service. Smaller brokers and agency traders are unable to put up the capital to meet client demand and an outage on the main market three years ago would have seen these smaller institutions heading for the nearest pub.

Alternatives are born

In recent years, however, changes in regulation have given birth to a range of alternative electronic trading platforms on which firms are still able to trade during disruptions.

These include exchange-like platforms known as multilateral trading facilities, such as Chi-X Europe and Bats Europe, and a variety of broker-owned internal platforms on which banks can electronically match up client orderflow.

While in theory brokers ought to be able to locate liquidity despite the absence of the LSE, in reality traders do not always favour alternative platforms during an outage. This proved to be true on February 25, when volumes on the large MTFs – which usually account for around 40% of the London market – traded at approximately a fifth of their average level.

This slump in market-wide volumes was widely perceived to be caused by a reluctance among buyside clients to trade electronically because they do not believe alternative platforms, including broker-run networks, are able to generate reliable prices during an outage.

Paul Squires, head of trading and securities financing at Axa Investment Managers, said: “There is a lack of confidence in the MTF prices, so when the primary [market] goes down, our fund managers become very risk-averse and generally on our advice prefer not to trade.”

These fears are vindicated by data provided by LiquidMetrix, a market data company, which shows the spreads on Bats, Chi-X and Turquoise to have been four times wider than normal. The situation was exacerbated by the timing of the outage, which occurred during the opening auction when prices are benchmarked.

But, while the buyside may be wary of the quality of execution on alternative markets, it is clear not all broker trading programmes (algorithms) are equipped to cope with such problems. Some liquidity-seeking algorithms, known as smart order routers, can be recalibrated to discount downed exchanges.

But not all routers are so smart, and some become confused by market disruptions, report brokers.
Richard Balarkas, chief executive of Instinet Europe, said: “Many brokers in Europe don’t smart order route and there are also many who rely upon vendor-provided routers – the effectiveness of which I’m sceptical about when the market is operating normally.”

The situation is not helped by the internal policies that govern how brokers execute. Some policies still oblige brokers to send orders to the LSE, despite the availability of other markets. Kee-Meng Tan, head of the Europe electronic trading group at Knight Capital, a top-three retail marketmaker for UK stocks, said: “Many retail brokers’ best execution policy includes only the primary exchange, meaning their clients are shut off when the LSE goes down.”

Privately, market participants believe that a good chunk of brokers need to improve their algorithms and update their best execution policies to boost liquidity during an outage.

Working more closely with clients to explain their options during potential disruptions is also one way to assuage client fears, according to Stuart Baden Powell, head of European electronic trading strategy at RBC Capital Markets. “Consultation with the buyside around what types of liquidity they would encounter and how the router will interact with that liquidity is the key to any decision to continue trading.”

Bringing down spreads during outages, however, is a broader structural problem and will take a concerted industry effort. Paul O’Donnell, chief operating officer of Bats Europe, said the fear of unreliable pricing on alternative venues often proves to be self-fulfilling.

He said: “The more firms that are happy to divert to the alternative venues the better the spreads will be.”
Improving the situation

However, data from other smaller outages, in particular the NYSE Euronext’s, suggest the situation is improving. Although no aggregate liquidity moved from NYSE Euronext to the MTFs, the level of trading on the MTFs remained at normal levels.

O’Donnell said: “We are on the cusp of moving to a dynamic where the market is able to trade normally during a primary outage, provided this does not occur during the opening auction.”